How Credit Cards Work: 6 Things You Should Know

Most people have an intuitive understanding of how credit cards work: You use the card for purchases and the bank charges you interest on the unpaid balance. Unfortunately we don’t always read the fine prints on our credit card agreement, or worse, we might even get approved for a credit card without actually getting all the relevant information. So to help you make a better use of your credit card, here are 7 things worth knowing next time you proudly swipe that Platinum:

1. APR vs APY: You pay more than the interest rate advertised

Banks will generally advertise their credit cards through the Annual Percentage Rate (APR), which is a close estimate of the actual rate charged to you: the Annual Percentage Yield (APY) or Effective Annual Rate (EAR). The APR, generally understated by a couple of decimals, accounts for simple interest whereas the APY accounts for compound interest. In reality, because you pay interest on the interest you already owe, you should always convert the published APR to its APY equivalent in order to obtain the true rate that you will be charged. For that purpose, use the following conversion formula:

Where m represents the number of compounding periods of the APR (m is 365 for daily compounding and equals 12 for monthly compounding). So when applying this formula, you will notice that the difference between what is sold to you and what you actually pay can be quite high. For example, for a credit card quoted at 29.99% APR compounded daily, the actual rate charged (APY) will be 34.96%. If the APR is compounded monthly the APY will be 34.48%.

2. Purchase interest rates can be calculated in several ways

The most common methods are:

Average daily balance: Under this method, the monthly interest you are charged is a function of the average balance over the billing cycle (i.e. sum of the daily outstanding balances divided by the number of days covered in the cycle). The unpaid portion of the amount owed (after the grace period) gets added to your outstanding balance on the next bill.

Adjusted balance: The interest charged is based on the balance at the end of your billing cycle.

Daily accrual: Each day, the account balance is multiplied by the annual rate divided by 365. At the end of the cycle the total interest is billed to the account.

Previous balance: You are charged interest back to the date you made the purchases until you make a payment that covers the full amount of these purchases.

3. Non-purchase transactions are charged at higher interest rates

Banks typically charge higher interest rates on balance transfers, credit card cheques and cash advances. For example, you may get charged 17.99% on purchases but 19.99% on balance transfers and 24.99% on cash advances.

4. Promotional rates don’t last

Promotions like zero-interest cards are just a way to incentivize customers to use their credit card more often or to have them transfer their existing balance from another financial institution. You should always beware of the terms of the promotion, i.e. when it ends, and the standard rates that apply once the promotion is over (these lasts are generally much less competitive than 0% !!!). Also, keep in mind, standard interest rates can vary as a function of your credit score or your delinquency rate.

5. Credit cards have plenty of additional fees

In addition to charging interest rate on your purchases, banks make money by applying fees on your credit card whenever possible. Therefore, transaction fees (generally a percentage of the transacted amount) may be charged for wire transfers, balance transfers, cash advances and credit card cheques. Account fees are generally fixed amounts charged for usage over limit, returned payments, bouncing cheques, extra account statements or inactive credit balance. Not also that as convenient as it is to use your credit card when you travel abroad, transactions made in a foreign currency will generally be charged an extra fee. For example, MBNA’s Platinum Plus Mastercard will charge you a fee equal to 2.5% of the transaction amount after it has been converted.

6. The grace period does not apply to every transaction

the grace period is the amount of time you have to pay your balance in full without paying a finance charge. Generally it will be 21 days. However cash advances and balance transfers don’t typically have a grace period and begin accruing interest as soon as the transaction posts to your account. Additionally, new purchases may not have a grace period if you already have a balance on your credit card when the purchase is made.

So as basic as it might sound, the best and most economical way to use your credit card is by always paying the full amount owing on your credit card before the payment due date and by avoiding using the credit card for non-purchase transactions like cash advances, wire transfers, cheques or money orders.

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Bobby Finance is a financial literacy blog for young professionals and beginning entrepreneurs. The site explains in simple terms how finance and the global economy operate and how they impact your everyday life. The aim is to empower you with the ability to understand how money works, how it’s made, how it’s managed and how it either gets in your pockets or out of it. Bobby Finance is the platform where you can get smart and simple answers to the most complex financial issues. The blog provides you with tools to make informed and effective decisions about your money, your business, your career and your role in the global economy.